Changes made by tax reform have caused companies to reevaluate their structures. This reevaluation extends to the most fundamental decision: choice of entity. The choice of entity decision now frequently hinges on two key, and competing, changes: the reduction of the corporate tax rate from 35 percent to 21 percent and the enactment of new section 199A—commonly referred to as the “pass through” deduction. Commentators have extensively discussed how these (and other) changes alter the traditional choice of entity analysis. But this commentary frequently overlooks section 1202.
When it applies, section 1202—coupled with the reduction in the corporate tax rate—may result in significant tax savings. Owners of entities currently operating as LLCs or partnerships may therefore benefit from converting such entities to C corporations and owners of S corporations (as well as LLCs and partnerships) may benefit by causing such entities to contribute their operating assets to C corporations. Prospective purchasers of such entities, including private equity funds, should also consider section 1202 when evaluating targets and structuring acquisitions.
Section 1202 excludes (subject to limits) gain from the sale of “qualified small business stock” (QSBS). In general, to qualify as QSBS:
- The stock must be stock in a domestic C corporation acquired from the corporation at original issue in exchange for money, property (other than stock), or services;
- The aggregate gross assets of the corporation (measured by adjusted basis) must not exceed $50 million immediately after the original issuance and must not have exceeded $50 million at any time prior to the original issuance; and
- During substantially all of the shareholder’s holding period, at least 80 percent of the corporation’s assets must have been used in the active conduct of a qualified trade or business.
The exclusion is available only for non-corporate shareholders that acquired the stock after August 10, 1993, and have owned the QSBS for more than five years.
Gain eligible for the exclusion (“eligible gain”) is limited to the greater of (1) $10 million (reduced by eligible gain taken into account during prior years) and (2) 10 times the taxpayer’s aggregate adjusted basis of the QSBS sold during the taxable year. The percentage of eligible gain excluded by section 1202 depends on when the shareholder acquired the QSBS. For QSBS acquired before September 27, 2010, the exclusion is either 75 percent or 50 percent (any eligible gain not excluded by section 1202 is subject to tax at a 28% rate.) All eligible gain from the sale of QSBS acquired on or after September 28, 2010, is excluded. This 100 percent exclusion was made permanent by the 2015 PATH Act.
Companies considering operating as C corporations should consider section 1202. Companies currently operating as LLCs or partnerships can become C corporations by, for example, electing corporate status, converting under state law, or transferring their assets to a newly organized corporation. Shareholders of existing S corporations cannot qualify for section 1202 by simply revoking the corporation’s S election because only stock that is QSBS when original issued qualifies. However, shareholders of existing S corporations may qualify for the benefits of section 1202 by, for example, causing the S corporation to transfer its assets to a domestic C corporation in a section 351 exchange. The S corporation would serve as a holding corporation and, if properly planned, gain recognized on the sale the C corporation’s stock could be excluded under section 1202. Note: if an S corporation has more than $50 million of assets, shareholders might still be able to qualify for the benefits of section 1202 if the S corporation’s assets were to be transferred to multiple wholly-owned domestic C corporations.
There are, of course, several other considerations that must be analyzed before converting. For example, purchasers will not receive a cost basis in the assets of an acquired C corporation (or an immediate deduction for purchased assets) without triggering corporate-level tax. They may therefore reduce the purchase price to account for the lost tax benefits (relative to an acquisition of an LLC or partnership). State and local income and franchise taxes should also be considered. Finally, the possibility of legislative changes—in particular, an increase in the corporate tax rate—cannot be ignored.